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Urgent Need For Fiscal Consolidation

Monday, January 30, 2012
Deepak Sahijwala

“Considering the egregious implications of large fiscal deficits, which are well-known, there is an urgent need for decisive fiscal consolidation, which will shift the balance of aggregate demand from public to private and from consumption to capital formation. This is critical to yielding the space required for lowering rates without the imminent risk of resurgent inflation. The forthcoming Union Budget must exploit the opportunity to begin this process in a credible and sustainable way." This advice comes from Dr. D. Subbarao, Governor of the Reserve Bank of India.

So what does it mean? Reading between the lines it clearly hints that the forthcoming Budget is crucial in the sense that it would be directing the economic path of the nation and therefore policy choices could either hinder or help the nation’s progress.

In fact, although the RBI believes that the economy will exhibit a modest recovery next year, with growth being slightly higher than during this year, it clearly understands that the economic risks have not mitigated totally.

So what are the risks staring the economy in its face? In the Third Quarter Review of Monetary Policy 2011-12 presented last week, the RBI spelt out the risks factors that could affect its projections of growth and inflation for 2011-12 and listed seven of these.

First, sovereign debt concerns in the euro area pose a major downside risk to the overall growth outlook. The second major risk emanates from the slowdown of capital flows in the face of a widening current account deficit. Third, global energy prices continue to pose a risk to growth and inflation due to geo-political factors and the global macroeconomic situation. Fourth on our list of risks is that there are signals of increasing risk aversion by banks, which could adversely affect credit flow to productive sectors of the economy.

Fifth, inflation in respect of protein-based items remains high due to structural imbalances. In the absence of appropriate supply responses, risk to food inflation will continue to be on the upside. Next, there is a large element of suppressed inflation as domestic prices of some administered products do not reflect the underlying market conditions. Revision in domestic administered prices will add to inflationary pressures, although I should note that such revisions are necessary to maintain the balance between supply and demand.

And finally, the fiscal deficit of the government could potentially crowd out credit to the private sector.  Moreover, slippage in the fiscal deficit has been adding to inflationary pressures and it continues to be a risk for inflation.

The bottom line is that while the situation seems to be improving, we are not out of the woods… not yet.

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